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A Productive Debate

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If there's anything like an elixir for aneconomy, it's productivity growth. Economic theoryholds that when output per worker rises, so shouldwages, and hence living standards. In practice, that'swhat transpired so impressively in the United States duringmuch of the last century.

But recent data suggests that for many workers, theelixir has lost its potency. Last August, the EconomicPolicy Institute announced that while U.S. labor productivityrose 16.6 percent between 2000 and 2005, themedian family income fell nearly 3 percent after adjustingfor inflation. Similar outcomes have been reportedfor individual states. In New York, for example, the FiscalPolicy Institute said that although productivity in thatstate has risen more than 9 percent since 2000, average realwages have grown just 1.6 percent. In Massachusetts,productivity growth has increased nearly 50 percentsince 1989, but median annual earnings have risen just1.2 percent after inflation, according to the Center forLabor Market Studies at Northeastern University.

As a result, many observers contend that the linkbetween productivity and pay is broken. Employees areworking harder and smarter, they charge, but are reapingno reward for the extra effort. A slack job market,globalization, immigration, and the decline of unions arecommonly blamed for the lack of wage growth.

Some economists, however, are more sanguine aboutthe apparent disconnect. They note that wages havesteadily fallen as a share of total compensation; benefitslike health care and pensions now account for nearly 30percent of overall pay. Growth of total compensationprovides a better comparison with productivity growth,they maintain, and on this score, they see little cause foralarm in the latest numbers.

Tale of Two Deflators

One thing is clear: since 1995, productivity growth hasexperienced a strong revival. In the prosperous yearsbetween 1947 and 1973, productivity grew on averageabout 2.8 percent a year. Then, for reasons that continueto be debated, annual growth slowed to 1.4 percentbetween 1973 and 1995. Productivity growth has sincepicked up, averaging about 2.8 percent a year between1995 and 2005.

How well total compensation has kept up with productivitydepends on how you adjust for inflation. LastJuly, Edward Lazear, chairman of the White House'sCouncil of Economic Advisers (CEA), celebratedU.S. productivity in a speech atthe National Economists Club. A chartaccompanying his speech showed thatgrowth in average real hourly compensation hasclosely tracked productivity growth since1950. Lazear used the price index for nonfarmbusiness output to adjust compensationfor inflation.

And that is how it should be done,according to Gregory Mankiw, formerCEA chairman and professor of economicsat Harvard University. "Productivity iscalculated from output data," commentedMankiw on his blog last August. "Fromthe standpoint of testing basic theory, theright deflator to use to calculate realwages is the price deflator for output."

But in a draft paper released last October,economists Jared Bernstein andLawrence Mishel of the Economic PolicyInstitute also plotted compensation onLazear's chart using a consumption deflator(see "Mind the Gap?" at the end of this article). Theresult is that compensation begins to fallbehind productivity in the 1970s, and thegap widens to the present day. In justifyinguse of the Consumer Price Indexdeflator, which has grown faster than theoutput deflator, Bernstein and Mishelargue that "consumers are not buyingmachine tools and drill presses; they arebuying gas at the pump, housing services,haircuts, and so on, all of which areweighted more heavily in the CPI than inthe [output] deflator."

Wage growth may be expected to lagproductivity growth when an economyemerges from recession. Lazear is confidentthat wages will eventually begin tocatch up, as they have before. "2006 hasseen significant increases in nominalwages above the levels of past years," hesaid in July. But Bernstein and Mishel arefar more skeptical.

Meanwhile, some observers worrythat total compensation growth is slowingdown. Last August, The New YorkTimes noted that the inflation-adjustedvalue of worker benefits has fallen sincethe summer of 2005.

Unequal Wage Growth

Robert Gordon, a professor of economicsat Northwestern University and a prominentproductivity expert, insists that "dataissues" explain away the 3.4 percentannual growth gap between productivity and average realhourly wages for the four years ending inQ1 2005. Those issues (which include differentdeflators) are discussed in Gordonand Ian Dew-Becker's 2005 paper,"Where Did the Productivity Growth Go?Inflation Dynamics and the Distributionof Income."

The authors point out that labor'sshare of national income has remainedmore or less constant over the past 50years. "Somewhat surprisingly," theywrite, "in light of comments about labor'losing out' from the productivity growthupsurge, labor's share in the total economyactually increased at an annual rate of0.25 percent over the period 1997–2005."

But Gordon and Dew-Becker see adisturbing trend in the distribution oflabor's share. According to their analysis,only the top 10 percent of nonfarm workerssaw their wage growth match the averagerate of productivity growth since1997. Within the top 10 percent, anotherdisproportionate amount of wage growthaccrued to the top 1 percent. Overall, theyreckon, half of labor's income gains since1997 went to the top 10 percent of theincome distribution.

"The post-1995 productivity growthrevival did not automatically signal goodnews for the majority of American workersand households," conclude Gordonand Dew-Becker. "Indeed, to the extentthat the productivity growth 'explosion' of2001–2004 was achieved by cost-cutting,layoffs, and abnormally slow employmentgrowth...the historical link between productivitygrowth and higher living standardsfalls apart. Not only have the bottom90 percent of American workersfailed to keep up with productivitygrowth, many have been harmed by it."

Significant or not, the gap betweenpay and productivity is a subject thatwon't go away, particularly now that controlof Congress is passing to the labor-friendlyDemocratic Party. There is muchtalk of raising the federal minimum wagefrom its current $5.15 per hour, perhapsto $7.25. Jared Bernstein says that lawmakerscould reintroduce the EmployeeFree Choice Act, which would make iteasier for unions to organize. Expectpoliticians to explore other, perhaps moredramatic, ways to bring pay and productivitytogether.